How central banks are relieving a major liquidity crisis

Independent Australia26 Mar 2020, 16:52 GMT+10

Having been impacted by the COVID-19 pandemic, the RBA is taking measures to ensure commercial banks can still function as lenders, writes Tom McCarthy.

OVER THE PAST FEW WEEKS, Australia's central bank, the Reserve Bank of Australia, has announced a series of extraordinary measure to support the "repo" market - a short-term money market between the RBA and banks - which is experiencing significant strain as a flow-on effect of the coronavirus. The U.S. Federal Reserve has done the same, injecting a whopping US$700 billion into its equivalent market.

But what is this actually designed to achieve?

While it might seem a bit cliched, in order to get a proper understanding of why these measures are being deployed by central banks, we have to consider the infamous collapse that befell the global financial system around 2008.

The Global Financial Crisis, for all its drama, left us with several key lessons. And financial regulators the world over seem to have devoted most of the past decade to ensuring that those lessons are suitably reflected in the current-day machinations of financial markets.

One such lesson included that, in order for banks to remain solvent and functional during a financial markets crisis, the quality of assets they hold as security against the loans they make needed to improve from the time of the GFC. Perhaps the easiest way to conceptualise this is by thinking about it in terms of an individual loan. Where a bank makes a loan, it is required to take "collateral" from the borrower. Collateral refers to the assets the borrower pledges as security, giving the bank the right to sell those assets if it defaults on the loan.

However, as you can imagine, if the pledged assets are Uzbekistani government bonds or relate to the sub-prime housing market (as was the case in the GFC), then one should not assume that the collateral will hold its book value in the face of a large-scale financial crisis, which happens to be the very time when the bank is most likely to need to sell those assets to cover a default by the borrower.

Since the GFC, laws with fancy names like "Basel" have been introduced, encouraging banks to de-risk their positions by having access to liquid, stable assets, should they need to realise collateral or pledge it to raise cash. To this end, values are assigned to different categories of collateral assets, to reflect risk. Aside from cash, the highest quality asset of them all is a U.S. Government bond, commonly known as the "UST" (U.S. Treasury).

In addition to the UST being considered a high-quality asset in the eyes of regulators, it also has the added benefit of being tradeable in the "repo" market, where banks and other large financial institutions temporarily convert their USTs to access the most valuable commodity of them all - cash.

Seemingly, the UST reigns supreme in the modern banking world.

However, in recent times, that supremacy has been brought into question. In mid-September last year, the repo market spiked, implying that there wasn't enough cash available in the system to satisfy banking liquidity requirements. But just when banks might have started to doubt the power of the UST, the U.S. Fed stepped in to save the day, temporarily injecting around US$300 billion in cash to restore normality. But perhaps also enabling the view that USTs are as good as cash.

The only problem is, they're not. While ordinarily USTs might be converted to cash in the repo and other short-term markets, ultimately this is a market function and not a legal right of the UST holder. If there's insufficient spare cash to be traded in the market, then banks, notwithstanding that they are UST-rich, might be left cash-poor. This presents a real challenge in the current environment, as corporate and other bank customers face an extreme and sudden hit to income and therefore find themselves in desperate need of cash. Companies cannot pay their staff and bills in USTs.

Take the global airline giant Boeing, for example, which has reportedly been forced to draw down (borrow from banks) the total amount of a US$13.8 billion facility, the majority of which it was meant to be keeping up its sleeve for a rainy day. This will, of course, not be a unique scenario. Suddenly, big banks and financial institutions around the world need to convert their collateral into cash - and fast. But if all the banks in the repo market need cash at the same time, then there's no one on the other side of the trade to supply it.

That's where the likes of the U.S. Fed and RBA come in. Having quickly realised the dire and urgent need to relieve this market conundrum - which threatens to freeze up the entire banking system and, in turn, the economy - central banks have scrambled to get enough cash into the system to ensure that commercial banks can continue to fulfil their crucial function of lending. The RBA is triaging our repo market, committing billions and providing longer terms for repayment.

What becomes of repo markets is now anyone's guess. Almost overnight, they have gone from a mechanism to smooth out routine liquidity ebbs and flows to an emergency cash facility of epic proportions. It's hard to see corporates and other borrowers being in a position to pay down debt anytime soon, as the revenue impact caused by the coronavirus persists. So, at least for the foreseeable future, central banks are going to become exactly what their name implies. Central. Vital. The economy's last line of defence from widespread insolvency. Hopefully, they have enough ammunition.

Tom McCarthy is a corporate analyst whose areas of experience include money markets and collateral management.